Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Thursday, November 19, 2015

The Income Awakens

Despite the chatter of politicians, we are not soon filing income taxes on the back of a postcard. A major reason is the calculation of income itself. There can be reasonable dispute in
calculating income, even for ordinary taxpayers and far removed from the rarified
realms of the ultra-wealthy or the multinationals.

How? Easy. Say
you have a rental duplex. What depreciation period should you use for the property:
15 years? 25? 35? No depreciation at all? Something else?

And
sometimes the reason is because the taxpayer knows just enough tax law to be
dangerous.

Let’s talk
about a fact pattern you do not see every day. Someone sells a principal
residence – you know, a house with its $500,000 tax exclusion. There is a
twist: they sell the house on a land contract. They collect on the contract for
a few years, and then the buyer defaults. The house comes back.

How would
you calculate their income from a real estate deal gone bad?

You can
anticipate it has something to do with that $500,000 exclusion.

Marvin
DeBough bought a house on 80 acres of land. He bought it back in the 1960s for
$25,000. In 2006 he sold it for $1.4 million. He sold it on a land contract.

COMMENT: A land contract means that the seller is playing bank.
The buyer has a mortgage, but the mortgage is to the seller. To secure the
mortgage, the seller retains the deed to the property, and the buyer does not
receive the deed until the mortgage is paid off. This is in contrast to a
regular mortgage, where the buyer receives the deed but the deed is subject to
the mortgage. The reason that sellers like land contracts is because it is
easier to foreclose in the event of nonpayment.

DeBough had a gain of $657,796.

OBSERVATION: I know: $1.4 million minus $25,000 is not
$657,796. Almost all of the difference was a step-up in basis when his wife passed
away.

DeBough
excluded $500,000 of gain, as it was his principal residence. That resulted in
taxable gain of $157,796. He was to receive $1.4 million. As a percentage,
11.27 cents on every dollar he receives ($157,796 divided by $1,400,000) would
be taxable gain.

He received
$505,000. Multiply that by 11.27% and he reported $56,920 as gain.

In 2009 the
buyers defaulted and the property returned to DeBough. It cost him $3,723 in
fees to reacquire the property. He then held on to the property.

What is
DeBough’s income?

Here is his
calculation:

Original gain

157,796

Reported to-date

(56,920)

Cost of foreclosure

(3,723)

97,153

I don’t think so, said the IRS. Here
is their calculation:

Cash received

505,000

Reported to-date

(56,920)

448,080

DeBough was outraged.
He wanted to know what the IRS had done with his $500,000 exclusion.

The IRS trotted
out Section 1038(e):

(e) Principal residences.

If-

(1) subsection (a) applies
to a reacquisition of real property with respect to the sale of which gain was
not recognized under section 121 (relating to gain on sale of principal residence); and

(2) within
1 year after the date of the reacquisition of such property by the seller,
such property is resold by him,

then, under regulations prescribed by the Secretary, subsections (b) , (c) , and (d) of this section shall not apply to the reacquisition of such property and, for
purposes of applying section 121 , the resale of such property shall be treated as a part of the
transaction constituting the original sale of such property.

DeBough was
not happy about that “I year after the date of the reacquisition” language.
However, he pointed out, it does not technically say that the $500,000 is NOT
AVAILABLE if the property is NOT SOLD WITHIN ONE YEAR.

I give him
credit. He is a lawyer by temperament, apparently.DeBough could find actionable language on the
back of a baseball card.

It was an
uphill climb. Still, others have pulled it off, so maybe he had a chance.

The Court
observed that there is no explanation in the legislative history why Congress
limited the exclusion to sellers who resell within one year of reacquisition.
Still, it seemed clear that Congress did in fact limit the exclusion, so the
“why” was going to have to wait for another day.

DeBough lost
his case. He owed tax.

And the Court was right. The general rule –
when the property returned to DeBough – is that every dollar DeBough received was
taxable income, reduced by any gain previously taxed and limited to the overall
gain from the sale. DeBough was back to where he was before, except that he
received $505,000 in the interim. The IRS wanted its cut of the $505,000.

Yes, Congress
put an exception in there should the property be resold within one year. The offset
– although unspoken – is that the seller can claim the $500,000 exclusion, but
he/she claims it on the first sale,
not the second. One cannot keep
claiming the $500,000 over and over again on the same property.

Since
Debough did not sell within one year, he will claim the $500,000 when he sells
the property a second time.

When you
look at it that way, he is not out anything. He will have his day, but that day
has to wait until he sells the property again.

And there is
an example of tax law. Congress put in an exception to a rule, but even the
Court cannot tell you what Congress was thinking.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.